2022 Economic Outlook
As the year 2021 has come to an end, there are some important economic variables that we would like to discuss. Since the beginning of the pandemic in 2020, the US economy went through many changes – from a deep drop in GDP growth, deflation, and skyrocketing unemployment; all followed by a speedy recovery with GDP growth of around 5 percent in Q3 2021 (the highest in a longtime), unemployment as low as 4.2 percent, and inflation above the two percent long-run goal set by the Federal Reserve Bank (1).
The biggest issue that is on everyone’s mind right now is inflation. According to the US Bureau of Labor Statistics, the Consumer Price Index for urban consumers rose 6.8 percent for the 12 month period ending in November 2021. The indexes for gasoline, shelter, food, used cars and trucks, and new vehicles were among the larger contributors. The index for all items excluding food and energy rose 4.9 percent over the last 12 months, while the energy index rose 33.3 percent over the last year, and the food index increased 6.1 percent (2).
Why The Inflation Increase?
The simplest explanation is, of course, a drastic increase in the money supply. Consider, if you will, the following example: if the economy produces nothing but one candy bar and prints one dollar – the value of one dollar is one candy bar. If the economy is printing two dollars and is still producing one candy bar, the value of the dollar will drop to half of the candy bar. In order to keep the fed funds rate at near zero, the Fed is buying tremendous amounts of securities, thus injecting money into the economy. M2 increased to an unprecedented 7.7 billion real dollars (1982-84 base year) in November 2021 compared to 5.9 billion in November 2019. Part of this money stock is explained by Federal Reserve purchases, as well as fiscal packages (e.g.: $791 billion in PPP loans of which $672 billion were applied to be forgiven)(4). Two graphs below show the level of M2 in billions of dollars and annualized growth of M2 (3) (to illustrate COVID’s impact the graphs cover periods from 2005 to now).
Given this amount of money floating around, inflation seems to be the logical consequence. Now the question becomes: how big is the money multiplier? Each dollar going through the economy multiplies by being used in numerous transactions and by passing in and out of the banking system, so if the multiplier isn’t broken, we can expect growing inflation. The last time the US economy experienced such an increase in monetary base and in fiscal stimulus was in 2007-2009, but inflation didn’t increase. The reason for the crisis at that time was different - a collapse in the mortgage backed securities market led to a collapse of the financial system; an absence of lending and borrowing led to a broken multiplier, which, in turn, prevented inflation.
Strange Bedfellows
Drastically larger money supply is not the only culprit for higher inflation. A second reason that comes to mind is a significant increase in consumption followed by massive supply chain issues. During the quarantine, consumption increased significantly. According to Bureau of Economic Analysis data, Q3 2020 real (adjusted for inflation) personal consumption expenditure from the previous period increased by 41.4% and continued to increase until Q4 2021. This increase in consumption didn’t arise because of inflationary expectations. Simply put, it stems from lockdown boredom. People had nothing better to do and nowhere to go (we all remember that sudden urge to exercise on a Peloton, bake industrial amounts of cookies, build those bookshelves, or, like Clement, start buying smart-home devices). Increase in demand always leads to an increase in prices.
At the same time, many businesses were closed during the pandemic, decreasing the supply of many goods. Inflationary pressure is compounded by production issues caused by the “great resignation” and a lot of early retirements (to illustrate this point, we can just think how much we were really willing to pay for those items that were in shortage – like that precious roll of toilet paper).
Transitory, or not…?
Inflation caused by these changes can be transitory. It is already visible that the increase in personal consumption is slowing down. The labor force participation rate has increased to an almost pre-pandemic level (in November this rate increased to 61.8 percent, compared to 61.1 percent in February 2020). People joining the labor force will help resolve the employee shortages which many businesses are experiencing. These changes indicate that some part of the inflation we see is transitory and makes the outlook for 2022 less bleak.
Another reason for inflation is wage increases. Due to still lower labor force participation rates, as well as a shift towards self-employment, there is a high shortage of workers, which, of course, is leading to increased wages. Wage increases can be seen across all industries (5). Below is a graph showing growth in Employment Cost Index: Wages and Salaries: Private Industry Workers. Wage increases are especially noticeable in earnings for the lowest paid first quartile earners. For example, earnings of the first quartile workers who are over 25 years old and do not have a high school diploma went from $456/week in Q4 2019 to $493/week in Q2 2021.
This wage increase can be very noticeable for many small- to medium-sized businesses that rely on lower-skilled workers. To offset higher salaries' impact on profit margin, Employers who are able to, increase prices creating yet more inflationary pressure. By the nature of things, wages are strongly downwardly rigid (meaning it is easier to increase a wage than to decrease it). Conclusion: the portion of inflation due to wages is probably here to stay for at least the medium-term.
So… Now What?
As a response to the inflationary environment, the Federal Reserve is going to reduce it’s monthly asset purchases at a rate that is projected to end by March 2022. A Federal Open Market Committee statement from December 2021 indicates that the Fed Funds rate will be kept at 0-¼ percent, but is prepared to adjust the monetary policy in the future (6). Eventually, the inflationary threat will result in a policy of increased interest rates. Higher rates will lead to decrease in inflation and, consequently, slow down GDP growth. In the current situation, forecasting what really will happen is a pretty hopeless endeavor: we really can’t predict how new COVID variants and corresponding government policies will affect labor markets and supply chains. The general trends above suggest that the economy is strong (possibly even overheated) and inflationary at the moment. The macroeconomic policies usually employed in these inflation battling situations result in tapping the brakes on the economy along with higher rates of unemployment.
What to Expect?
Continuing strain on profit margin due to persistent inflation, increased labor costs and supply chain issues
Likelihood of multiple Federal Fund rate increases (and consequently other interest rates) this year
Possibility of increased unemployment as a consequence of increased interest rates in the 2nd half of the year, helping to solve worker shortage issues
Consider reassessing internal processes and investing in automation technology to help decrease costs across the organization
Thank You - and Happy New Year!
Rita George
Managing Partner
Clement George
Managing Partner
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Footnotes:
1: Testimony by Chair Powell on coronavirus and CARES Act - Federal Reserve Board
2: Consumer Price Index-November 2021
3: M2 is a measure of the U.S. money stock that includes M1 (currency and coins held by the non-bank public, checkable deposits, and travelers' checks) plus savings deposits (including money market deposit accounts), small time deposits under $100,000, and shares in retail money market mutual funds.
4: PPP data
6: Federal Reserve issues FOMC statement
